FINRA issued a formal investor alert regarding the dangers of Non-Traded REITs two weeks ago, and since Ray Lucia regularly schlepps these poisonous products at his investment seminars, he evidently thought it was time to defend this almost indefensible "strategy" in print. For background, FINRA's alert can be read in full right here, and you can also click here to read Lucia's response on his website. I have reposted Ray Lucia's response in full below.
Lucia didn't have much of a choice but to admit that FINRA "finally got it right", but he did affirmatively decide to dismiss one of FINRA's chief concerns (that Non-Traded REIT dividends are routinely paid using proceeds from new investors, NOT earnings) with a dismissive waive of his commission-stuffed hand. His exact quote is "this is real estate folks", as if the practice of paying dividends that exceed cash flow is completely normal and acceptable.
Well "folks", I have some advice for you: be your own lifeguard. There may be some benefits to owning Non-Traded REITs for some people, but by and large these products are less of an investment strategy than they are a self enrichment scheme for the people who peddle them. Lucia is paid a significant upfront commission to sell these REITs to you (which he blandly re-characterizes below as "start up costs"), and while that commission comes straight out of your account, Lucia does not disclose this on your statement. Also, chances are good that a non-traded REIT sponsor paid some or all of the freight for the "educational seminar" you attended, and then billed the cost right back to its own investors. FINRA is highly concerned about these issues too, and very soon they may require Lucia to disclose these commissions and expenses to you in a much more transparent manner than he does now.
Bottom line: if FINRA "finally got it right", why was Lucia busy selling these things without acknowledging any of these issues when FINRA apparently had it all wrong? Before you allow Lucia to place one of his buckets over your head, take the time to read this post here, and this thread here. Finally, read this real world example of what happens when dividends are paid using money from new investors, not cash flow.
Lucia's full post follows (remaining hypocrisy to be dissected a later date):
Earlier last week, FINRA, the Financial Industry Regulatory Authority, finally got it right when it issued an alert to investors about public, Non-Traded Real Estate Investment Trusts. Those who have listened to my radio talk show, attended my retirement seminars, or read any of my books know that I am an advocate of the use of Non-Traded REITs as a potential income generator and diversification tool. Retirees and many pre-retirees need investments that provide immediate income for emergencies and opportunities along with their daily living expenditures (Bucket #1). These types of investments, especially today, usually yield very little. So they also need investments with a relative degree of safety and stability with higher potential earnings. To achieve this, one needs an intermediate time horizon (Bucket #2). And of course, most investors need long-term investments for potential income and growth (Bucket #3). Such investments are designed to provide higher capital appreciation as well as a hedge against future inflation. Some long-term investments also produce potentially higher yields which can be used for supplemental income. Combining the short, intermediate, and long-term investments into a segmented portfolio, and then distributing the income needed by spending down the safest accounts first (while allowing the riskier ones the time needed to potentially grow) is what I call The Bucket Strategy™.
Non-Traded REITs, especially those with low-to-moderate leverage and those which, upon stabilization, are covering the dividends they pay out of from actual cash flow, can, over a long time period, potentially achieve both income and growth. This makes Non-Traded REITs an attractive investment for many. However, Non-Traded REITs are complicated investments requiring a lot of due diligence on the part of the investor as well as the advisor.
Alarmingly, many advisors have not taken the time to truly understand how Non-Traded REITs work and where they might be an appropriate investment in a portfolio. Further, and perhaps more importantly, many advisors are unclear as to who is a suitable investor for such a product.
Distributions are not guaranteed and may exceed operating cash flow. This is real estate, folks. There are a lot of variables in determining the amount of the distribution, and in the early stages of raising capital for Non-Traded REITs the startup costs, distribution expenses, and acquisition fees all make it very challenging for Non-Traded REITs to pay distributions completely out of their earnings. That is why you should strongly consider the sponsor of the REIT, the track record of the manager, and the market cycle of the asset class in determining if the REIT has potential to cover distributions from cash flow or if they may need to reduce distributions in the future.
FINRA got it right. Below are some key highlights everyone should be aware of:
Distributions and REIT status carry tax consequences. Consult your tax advisor. Some REITs may be better invested in your taxable accounts while others may be better invested in your retirement accounts. Picking the right account to invest in REITs may provide you with a more tax-optimized investment portfolio.
Lack of a public trading market creates illiquidity and valuation. Don't buy the hype on the share redemption programs. Assume your investment is locked in for the next 10-15 years. Time is your friend when investing in these products. Valuations are important, but complicated. Don't be alarmed if your REIT re-prices lower. Maybe that is the time to consider other strategies like converting your REIT in your IRA to your Roth IRA. The valuation that is the most important is when you sell.
Early redemption is often restrictive and may be expensive. If you are following a long-term strategy then this is a non-issue. This should be your last resort. If you use this option, it will cost you. Should your REIT suspend the share redemption program, you may need to look to secondary markets. Be careful as there are substantial spreads that can wipe away all of your earnings (and then some) if you venture there.
Fees can add up. It's not inexpensive to buy real estate. There can be costs of up to 15% on average, meaning your REIT may only be working with 85 cents on the dollar.
Diversification can be limited. You must consider diversification of your Non-Traded REITs. Only buying into one type of asset class may create undue risk. You should consider buying into multiple types of real estate to spread your risk around.
Non-Traded REITs are complicated investments. They have relatively high acquisition costs and mark-to-market valuations that are required 18 months after the last dollar is raised. Therefore, the share price is almost certain to be lower in the early years. This can cause some investors to question the integrity of the product and even question the integrity of their advisor. It makes sense that a direct investment in real estate valued at potentially fire sale prices would indeed be lower after acquisition costs are factored in. This is why Non-Traded REITs belong in the long-term bucket. Real estate, like a freshly picked green tomato, needs time to ripen. In my opinion, many advisors by and large have not done a very good job of communicating this to their clients. The FINRA alert will surely cause advisors to be more diligent in their explanation of both the pros and cons of the Non-Traded REIT investment.
buildings3I have written, reported, and spoken on the subject of Non-Traded REITs many times over the years. I have a substantial investment of my own in several Non-Traded REITs. I've trained numerous advisors on the appropriate way to sell this type of investment and have been interviewed by financial writers on this topic on more than one occasion. Most everyone wants to draw comparisons between public REITs and Non-Traded REITs with the idea of suggesting one over the other. This is a mistake. Public REITs are stocks with high risk, big upside potential, and extreme volatility—just like any other stock. Non-Traded REITs have a relatively stable share price and typically a higher initial dividend yield, but do not have the big upside potential (at least not until they list and trade publicly).
The fact of the matter is that both public REITs and Non-Traded REITs belong in most portfolios. That's because they don't always move in the same direction at the same time. In our business, we call that a lack of correlation. A recent paper on the subject of REITs and Private Equity Real Estate Funds by Morningstar highlighted how public REITs outperformed the Private Equity REIT Funds over long periods of time. However, they also concluded that due to the risk reduction associated with private real estate, institutional investors should own both public and private real estate for a better balance of their total real estate allocation. I agree!
Non-Traded REITs are gaining greater popularity with invested assets of $77.9 billion as of June 30, 2011 (according to Blue Vault). They are very popular within the financial planning community because they fill clients' need for income at a time when yields are sparse. They are also popular because most Non-Traded REITs pay advisors up front rather than an annual, asset-based fee. But with that popularity is the potential for abuse. Hence the FINRA alert.
The bottom line is that Non-Traded REITs can play an important role in an investor's portfolio. But, like most Bucket #3 investments, they require time to work through the up and down cycles so that the investor can realize the full potential of a long-term investment providing both income and growth.